The Fed has come back to life

On Wednesday, it signaled to markets that the second
interest-rate hike of this economic cycle could come as early as
June.

And for the first time in a while, markets took the Fed very
seriously.

It's not so much that markets believe the Fed's specific timing,
but that they are suddenly taking its intentions much more
seriously.

Minutes
of the the Federal Open Markets Committee (FOMC) meeting
said Wednesday,

Most participants judged that if incoming data were
consistent with economic growth picking up in the second quarter,
labor market conditions continuing to strengthen, and inflation
making progress toward the Committee's 2 percent objective, then
it likely would be appropriate for the Committee to increase the
target range for the federal funds rate in June.

The explicit reference to June caused a swift reaction across
markets: Stocks fell, treasury yields spiked, the dollar gained,
and expectations in the Fed Fund Futures market shot up.

The Fed finally regained some control by reminding markets that
it's focused on progress on its dual mandate of full employment
and price stability.

"It was just the overall discussion about how the economy seems
to be on the right path," Omar Aguilar, chief investment officer
for equities at Charles Schwab Investment Management, told
Business Insider.

"The only reason why the Fed lowered the expectations earlier in
the year was really as a result of market volatility and less
about the strength of the economy."

In other words, the Fed managed to shift markets' attention to
the reality of a tightening labor market and slowly rising
inflation — in part due to recovering commodity prices.

But what about market volatility?

In March, the FOMC said global markets continued to
pose a risk to the US economy, and implicitly, to the
Fed's ability to continue raising interest rates.

In April, the
FOMC removed this language. But of course, that's not to
say the Fed's so-called third mandate — of market stability —
doesn't count.

"If we see a significant deterioration of global equity markets
or commodities, that would potentially give them a pause,"
Aguilar said.

"With implied probabilities of another hike by June falling
to near zero, this effectively took the reins of monetary policy
out of the Fed’s hands—a hike when probabilities are so low would
be incredibly disruptive," RBC Capital Markets' chief economist
Tom Porcelli wrote in a note.

Bank of America Merrill Lynch summed up how markets and the Fed
have apparently led each other:Bank of America Merrill Lynch

In one sentence, the Fed gets hawkish, markets panic, and
then the Fed retreats and markets recover.

As examples, BAML points to when the Fed delayed the end of
its bond-buying program in 2013 after treasurys sold off, and the
carnage in early 2016 after the first rate hike.

Stocks sold off on Thursday, so one could argue that we
were in the "markets tank" phase. Equities were rallying by
Friday, showing that this link can be as fragile as it is
instructive.

But BAML dived deeper to counter the narrative that Fed
hawkishness necessarily panics investors and continues this
vicious cycle. They studied Reuters market wraps between August
2015 and April for what the day's equity action was attributed
to. (Of course, there's never just one clear reason.)

"The results are not very surprising, confirming that the
big story of the last year is not fear of the Fed, but China and
oil," wrote Ethan Harris, BAML global
economist. BAML

But the question remains: Who is listening to whom?

"We have long argued that what matters for the USD is what the
Fed is saying rather than what the Fed fund futures market is
saying," wrote Daragh Maher, a currency strategist at HSBC, in a
note Thursday. The Fed could continue to nudge rate
expectations higher in the coming weeks, he said.

Maher expects the dollar to continue to rally, even as the Fed
keeps its options open for a June or July rate hike.

For some analysts, the dollar is the biggest market
consideration, as it became the major channel of monetary policy,
and rallied sharply between 2013 and 2015 on hawkish
expectations.

But returning to BAML's analysis, when there was no clear
impact of US economic data, China, oil, and the Fed, there was no
clear effect on stocks either.

"Maybe, just maybe, the hyper-ventilation about the Fed is
overdone?" Harris asked.

"Maybe continued calm in China and in the oil market mean a
continued risk-on trade in capital markets? And maybe the world
does not fold over every time the Fed sneezes?"